It was August 2014 and Novo Banco had just been created from the ashes of Banco Espírito Santo, Portugal’s failed lender. With its toxic assets relegated to a bad bank, all that was needed was an image — something to capture the spirit of a new era.

A phoenix might have worked, but Novo Banco tried something else: a green butterfly perched amid black and green letters. The wings “symbolised the first season of transformation and renewability”. But the green butterfly never quite took off as an idea, and was ditched before it made its way into the bank’s later promotional materials. The sense of optimism soon faded too.

At the end of December last year, five of Novo Banco’s bonds were wiped out. Institutional funds, including Pimco, were furious after their investments were transferred to the “bad bank”. The decision, made by the Portuguese central bank, improved Novo Banco’s capital position but it rattled markets.

“This was an arbitrary confiscation of assets,” says Philippe Bodereau, a fund manager at Pimco. “It should make investors question how European authorities are going to go about bank resolutions.”

The Novo Banco episode reflected a shift in the political mood in Portugal after years of austerity imposed by a three-year bailout programme. But it also reflected a new, much broader regulatory regime in Europe, intended to make bondholders — not taxpayers — liable when banks run into trouble. “The political risk for banking is very different to what it was pre-crisis,” says Sam Theodore, director in financial institutions at Scope Ratings, and formerly a regulator in Europe. “In order to protect taxpayers, regulators and governments are willing to hit investors.”The Novo Banco drama, which came just before new rules for bank failure from Brussels, set the tone for a difficult period for European banks. As global markets endured a tumultuous start to the year, scrutiny of the sector intensified. Italian bank shares hit record lows over bad loan fears. By early February, prices for the riskiest bank debt traded at distressed levels. Even senior debt, one of the safest ways to invest in banks, dropped sharply. No bank had failed, but markets were behaving as if a crisis was in the offing.

The chaos across markets has subsided and prices have recovered, but its implications have echoed at the very highest level. When the European Central Bank announced further rate cuts earlier this month, its president Mario Draghi said the new measures, in particular cheap financing for eurozone lenders, came “in an environment where the pricing of bank debt is volatile and uncertain”.

Though the market movements were blamed on a long list of factors, bank analysts kept returning to the seemingly isolated case of Novo Banco. Investors began to examine the way losses had been imposed and look for clues in a strange new universe of bank debt.

Crisis response

One of the least discussed aspects of the financial crisis was the impact, or lack thereof, on investors who held bank bonds. When the crisis struck, some of the safest bank bonds, known as “senior unsecured”, went mostly unscathed.

Now regulators have changed that equation, placing bondholders on the hook in the hope that banks can be made safer without public money. This means that bank debt — once far safer than many other types of corporate bonds — will become riskier.

“The thing that saved the whole financial system was the state,” says Lloyd Harris, an analyst at Old Mutual. “This is one of the reasons they’ve designed regulation like they have.”One emblem for this new regulatory philosophy is the coco bond. Engineered since the crisis and designed to transfer risk to sophisticated investors, contingent convertible bonds, now more commonly known as “additional tier 1” (AT1) capital, convert to equity or are written down when a bank’s capital falls below a certain level. In other words, when the bank loses money or its assets collapse in value, the bondholders lose money as well.This new kind of debt is part of a broader category referred to as “bank capital” — equity and equity-like debt loosely analogous to a deposit on a house. Banks issue these capital bonds to meet regulatory requirements, which demand more capital to make the system safer.

When banks run into trouble, this capital is in the line of fire. As the spectre of negative interest rates came to the fore this year — a result of central bank policies designed to boost lending — bank equities and capital bonds fell dramatically. In the first half of February, the index for coco debt fell nearly 8 per cent. A €1.75bn Deutsche Bank bond traded at close to 70 cents on the euro.After the coco sell-off, it became clear that markets for different kinds of bank bonds were deeply interconnected. Analysts at JPMorgan Chase warned that coco markets had become a “conduit for channelling bank equity stress into the broader credit market”.More worryingly, markets for bank funding — part of the fuel for loans — briefly closed down. At the March press conference, Mr Draghi said European banks “face sizeable forthcoming funding needs”.

Some signs of contagion had emerged in January with Novo Banco, and February in the coco bond market. After the Novo Banco losses, Mr Bodereau says investor attitudes towards risky peripheral banks had changed. “If a eurozone bank fails an adverse stress test scenario, the market will be extremely nervous,” he says. “The risk of institutional runs on those banks has increased materially post Novo.”

‘Tip of the iceberg’

In Basel on a brisk November day last year, Mark Carney was sitting in a room with half a dozen reporters. The governor of the Bank of England and head of the Financial Stability Board was announcing the latest step in the post-crisis regulatory drive. Senior bonds — that portion of debt which is not “bank capital” — were about to get riskier.“Ending ‘too big to fail’ may never be absolute because all financial institutions cannot be insulated fully from all external shocks,” Mr Carney had written to the G20 leading economies on the new international standards. “But these proposals will help change the system so that individual banks as well as their investors and creditors bear the costs of their own actions.”

These rules for “total loss-absorbing capacity”, or TLAC, followed the ideology of transferring risk from governments to markets. They were intended for the biggest global banks and came alongside a separate European directive on loss-absorbing bonds.Regulators, seeking to correct what was seen as the perverse immunity bank bondholders enjoyed in the crisis, required senior bank bonds to become “bail-inable” — meaning they would take losses when banks failed. Banks deemed “systemically important” would also need a certain amount of this debt to make sure there was enough of a cushion to absorb losses in a crisis. Bank bonds account for more than 30 per cent of all debt securities, more than twice as much as non-financial corporate debt.Different parts of the world had different approaches to meeting the requirements. In Germany, the law was changed. In the US and the UK, banks sold bonds out of their holding companies. Some of the characteristics of post-crisis “bank capital” bonds had been applied to a much bigger market. In the words of one investor, nearly all bank debt had now become coco-like — something engineered by regulators to take losses, albeit after a failure.“The real game changer was that senior unsecured became bail-inable,” says Gerald Podobnik, head of capital solutions at Deutsche Bank. “AT1 or cocos are not the cause of the problem. The reality is that the funding and capital structure of a bank is nearly completely bail-inable. That is new.”Everything looked more like a coco, but what did coco bonds look like? One of the biggest problems for investors is the ongoing changes to rules.In December, such uncertainty hit the coco market, when the European Banking Authority, a regulatory body, had stated an “opinion” on the market which seemed to imply interest payments on the bonds might be stopped sooner than expected.This regulatory confusion was linked to the sell-off. In February, the market suddenly looked dangerously complicated. Hedge fund managers theorised over whether bonds would eventually be bought back. In Switzerland, the price of a host of bonds that had become defunct late last year fell sharply and counter-intuitively.The confusion extends beyond cocos. “Ever since the crisis we are dealing with all kinds of initiatives, which are often tackling the same issues from different angles,” says Emil Petrov, head of capital solutions at Nomura. “The capital structure has more layers than ever before. It’s more difficult to explain than ever before.”The AT1 market in Europe stands at close to €100bn. The market for senior unsecured debt of the biggest banks globally was €4.26tn at the end of 2014, according to estimates by the FSB. Mr Podobnik points out that these new rules reduce leverage and thereby make the banking sector safer. But he points, also, to this difference in scale.“We are in a new world where the risk profile of bank instruments generally has changed,” he says.“As such the recent AT1 sell-off is sometimes seen as the tip of the iceberg.”

The meaning of failure

Even without a Titanic moment, these accumulated changes have an impact. Banks are braced to pay more to borrow from the markets, potentially adding costs to the loans they make to households and businesses. The struggle to price risk is linked to uncertainty. Many analysts suggest one of the biggest sources of uncertainty is the regulations themselves. “Investors open the newspaper every day and read about new proposals and they don’t know what to make of it,” says Mr Petrov. “The reality is there’s no getting away from the too big to fail issue.”A bigger test will come when a bank actually fails. The vital question then will be whether the shake-up in the structure of bank bonds will work. Novo Banco was not technically a failure, but the political complications that emerged were not encouraging. “What does the default of a bank mean?” says Mr Theodore. “Banks don’t just default like commercial companies. It’s not a real default situation. It’s a default-like situation which is triggered by the regulators themselves. That’s why it’s so imperative to look at the behaviour of the supervisors.” Novo Banco’s logo never took off, but it now looks almost prophetic. The whole affair has more than a hint of the butterfly effect about it.

Politics: Bailout blamed for failure to tidy up sector

Born in 2014 out of the country’s biggest banking failure, Novo Banco has become a test case for Portugal’s capacity to rebuild lenders out of the destruction wrought by the global financial crisis. For many, the collapse of its forerunner, Banco Espírito Santo, and the family business empire of the same name, marked a blow against “crony capitalism”.The “anti-austerity” Socialist government that took office in November also claims that the case illustrates how the previous centre-right administration — and, by implication, the EU, International Monetary Fund and European Central Bank — failed to deal with the problems facing Portuguese banking during a gruelling three-year bailout of the country from 2011 to 2014.BES imploded only months after Lisbon celebrated its “clean exit” from the adjustment programme, having used only about half of the €12bn that had been earmarked for banks out of a €78bn bailout. According to the new government and its far left allies, the exit was achieved only by sweeping problems in the banking sector “under the carpet”.After injecting €4.9bn into Novo Banco through the bank resolution fund, which is owned by all of Portugal’s banks, lenders are expected to sustain losses from its planned sale, which some analysts see as unlikely to raise much more than €1.5bn. In December, the new government set aside another €2.2bn to rescue a small Madeira-based bank. “Portugal has to turn the page on the instability of our financial system,” said António Costa, the prime minister, this month.He also distanced himself from the Bank of Portugal’s decision to impose losses of almost €2bn on some Novo Banco senior bonds. Criticism of Carlos Costa, the central bank governor (left), has been condemned by the centre-right opposition as an attempt to force him to resign.

We are travelers on a cosmic journey, stardust, swirling and dancing in the eddies and whirlpools of infinity. Life is eternal. We have stopped for a moment to encounter each other, to meet, to love, to share.This is a precious moment. It is a little parenthesis in eternity.